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Breaking Down Brexit

In a monumental and surprising decision last Thursday, Britain voted to leave the EU. APCM’s investment committee is analyzing the market implications of the vote to assess associated risk and identify any opportunities for our portfolios. All of our portfolios are U.S. centric and well diversified with little or no exposure to European banks. Additionally, many of our portfolios have a component in high quality bonds which actually went up in the market’s search of safe haven investments.

Many chapters of Britain’s departure remain to be told and it will take years to play out. The impacts to financial markets will become clearer in stages thus we should expect continued bouts of volatility. APCM is recommending a neutral weight to stocks vs. bonds and reminds us that selling into a panic is rarely the right decision. We will have more to say about this as events unfold and as we have more time for reflection and analysis.

Brexit and Asset Allocation

The European Union is on the verge of losing one of its members. Recent events are one for the history books. The first chapter is full of surprise and turmoil.

It began in the days leading up to the BREXIT vote when investors counted on early polls and the “bookmaker markets” as reliable predictors, showing the “remain” vote would prevail. The markets reacted optimistically bidding up stocks and selling bonds. The day before the historic referendum the S&P 500 was up over 2% and UK’s FTSE 100 index was up over 8% in US dollar terms for the week.

But Thursday, 10:00pm in Alaska, we learned that 51.9% of UK voters chose to leave the European Union. Financial markets responded harshly the next day as the S&P 500 lost -3.6% and UK’s FTSE 100 lost -3.2% in local currency terms. Once you factor in the 8% drop in the sterling the index was down -10% in dollar terms. The MSCI global stock index fell 4.8%, its biggest drop since August 2011.

The UK banking sector was hit hard selling off over 20%. London’s ability to remain a global financial center came into question. Concerns have arisen over the ability of UK based banks to easily sell services throughout the European bloc in the future. And UK interest rates are likely to stay “lower for longer” crimping bank profits.

High quality bonds rallied and yields dropped on these safe haven assets. Gold climbed almost 5% to 1315 at the close Friday.

For the entire week, the S&P 500 was down 1.6% while the FTSE 100 lost 1.9% in dollar terms and was up 2% in local currency terms.

Many chapters of Britain’s departure remain to be told. The economic and financial market implications will take several years to play out. The consequences of the BREXIT vote will only become clearer in stages.

In the coming months our investment committee will analyze the immediate and long term impacts of the vote. Highlights from our initial assessment are below.

Soon the UK will formally notify Brussels of their intention to leave triggering a two-year negotiation period to define their new relationship. In the meantime, the UK remains a member of the EU.

Geopolitical experts at Stratfor note that during the negotiation period the free movement of goods, services, capital and people between Britain and the Continent should remain unchanged until at least mid-2018. Any agreements between London and Brussels will then have to be ratified by EU member states as well as the EU and British parliaments, which could further delay the exit process.

Uncertainties during the negotiation period will likely depress corporate and consumer spending negatively impacting growth. Foreign direct investment will slow. The UK economy will weaken and a recession is possible. This downturn when considered in isolation is unlikely to produce a global recession, as the UK is only 4% of global GDP.

The UK stock market is comprised of many large international companies who derive much of their revenue overseas which stand to benefit from a weaker pound. This will offset some of the effects that Brexit will have on domestic earnings.

Major central banks will likely aim to keep rates lower for longer. The Bank of England has earmarked an equivalent of $344B dollars for potential stability measures and odds of a Fed rate hike in the next couple of months have gone down.

The results of the BREXIT vote provide an example of the difficulties in accurately predicting global macro events. Our portfolio decisions have always been based more on valuation and expected earnings growth.

By design APCM’s client portfolios are U.S. centric as our clients are invested to offset some liability held in dollar terms whether it is retirement expenses, endowment spending, or a regular distribution to provide budgetary support. Relative valuations and earnings expectations led us to slightly overweight developed international stocks late last year. Valuation just got better as prices have fallen, but the impact of BREXIT on economic growth and earnings remains to be seen.

Needless to say, we don’t take the BREXIT results lightly and will wait, reflect, and analyze as developments unfold. For now, we agree with one analyst who noted that it is better to wait for opportunities to be revealed by volatility than to be a part of it.

Brandy Niclai, CFA®CIO, Multi-Asset Strategies

Implication for the US Economy and Rates

We have pushed back our call for a rate hike from September to December. (The “futures markets” are now predicting an 80% chance that rates are unchanged through year end.) The Yellen Fed had already signaled a slower pace of rate hikes before the UK vote and this will only make them more cautious. They will continue to monitor events and be clear on their communications so as not to add to market volatility.

US Interest rates fell Friday on a “flight to quality” as the 10yr and 30yr Treasury decline 17 and 13 basis points, respectively. The 10yr Treasury currently yields 1.58% compares to a low in July 2012 at 1.39%. There have been three drivers that have pushed yields lower in the last couple of months (1) Brexit concerns (2) US political uncertainty (3) softer US economic data.

While US economic growth has been subpar, the economy should not feel much of an immediate impact from “Brexit”. US exports to the UK are not significant and are equivalent to 0.4% of US GDP. The US receives 3% of its imports from the UK so a weaker sterling relative to the dollar would have little direct effect on US inflation rates via import prices.

A key near term indicator will be the employment data out this Friday. And if “financial conditions” keep tightening – stocks fall, credit spreads widen, credit is hard to get – the economy will decelerate, but recession is still pretty unlikely at this juncture.

Financials had a dismal day both in bonds and equities. After a five-week rally bank stocks tumbled Friday with JP Morgan and Goldman Sachs off more than 7%. The irony is that the day before, the annual bank stress tests were released showing that all the major US banks had passed!

There is no question that the balance sheets of the US banks have much less leverage and have more capital compared to the 2008 crisis. Funding is more secure. Earnings have been sluggish owing to very low rates and narrowing interest margins. Still, we believe that the US financial system has adequate liquidity if a European banking crisis develops (unlikely, but possible) and spills over to the US. Perhaps the big US banks will take market share from London?

APCM has little to no exposure in European banks in fixed income portfolios.

Finally, I think the rest of the world still views the US as a safe haven. That will continue to give US stocks and bonds a bid from overseas.

Bill Lierman, CFA®CIO, Fixed Income

There’s Something Happening Here, What it Is Ain’t Exactly Clear

With thanks to Buffalo Springfield and my “youth”, perhaps these lyrics sum up recent events in Europe (Brexit most recently) and the US presidential election.

Brexit was a political earthquake and PM David Cameron will resign from office. It confirms the rise of anti-establishment populism (think Donald Trump and Bernie Sanders in the US) and offers a rebuke of unfettered immigration policies, free trade (globalization) and elite policymakers (like the unelected European Commission housed in Brussels) and maybe even dissatisfaction with big government.

In so far as the economics are concerned the near term uncertainty will likely dampen business “animal spirits” in the UK and maybe Europe, as some will sit on their hands to see what is next. But monetary policy is likely to stay looser for longer and fiscal policy may become more simulative as an offset to private sector caution. Besides, Britain and the EU have at least two years to negotiate the terms and conditions of exit. In the meantime, it is status quo in so far as business rules and regulations are concerned. By the way, after Brexit, Britain and the EU will continue to trade, just under different terms.

If Brexit foreshadows a retreat from globalization and a wavering on free trade by other countries (including the US where both Presidential candidates seem to embrace aspects of protectionism) that could pinch economic growth and corporate profits. It’s sand in the gears. If it encourages other EU nations to break away or abandon the euro that would be unsettling. We will just have to wait and react as events unfold.

On the other hand, these trends could induce a rethink by EU policymakers to embrace reform, loosen regulations, and encourage growth to keep current members in the fold. Who knows, maybe Great Britain will ultimately stay in if the EU compromises? Doubtful but…

We are early in the process with lots of unknowns. Unfortunately, that means higher risk premiums for risky financial assets, in the short term. In layman’s terms it means risk assets will trade cheaper and safe havens will be well bid. But for long term investors who can shoulder uncertainty, some assets may well go on sale signaling attractive future returns.